Sector rotation amid tax cuts and rate increases

The quarter was both profitable and frustrating. Many stocks with great earnings histories and reasonable valuations had a mediocre period, and other securities with less attractive metrics did relatively well. So our quarter was not nearly as good as it could have been. Growth stocks have greatly outpaced value stocks all year until June, so being a “conservative” value-oriented investor has been counterproductive. Small cap stocks have recently outperformed large cap issues, in part because they are less vulnerable to disruptions in international trade. The emerging markets turned in a very disappointing quarter due to trade tensions and rising interest rates. Housing and airline stocks retreated after impressive gains.

The best news is the rapid growth in the economy and the corresponding advance in corporate earnings. Domestic GDP grew at a 2.0% rate in the first quarter; a 2.8% pace in the year ending March 31. The latest earnings for the S&P 500 Index soared 26.5%. Analysts now estimate S&P 500 earnings of $161 for 2018, so the PE ratio based on an index level of 2721 would be 16.9. This valuation is a bit high, but not excessive. The 5-year average forward PE is 16.2 and the 10-year average is 14.4 – which arguably includes a period when PE ratios were too low coming out of the 2008 crash. If interest rates do not rise too much, this valuation level is sustainable – all else equal.

The earnings gains were not all due to tax cuts; revenue grew by an impressive 8.4% – the fastest in nearly a decade. But the market is a discounting mechanism and is sensitive to the rate of change. Investors must wonder how long earnings can power the market higher given the Fed’s program of gradually raising short-term interest rates and the Administration’s repeated protectionist thrusts causing increased trade jitters.

The bottom line is that the S&P 500 Index delivered a total return of 3.43% for the quarter.

So, is the best possible news already reflected in prices, or is a somewhat more irregular but continued move higher in store in the months ahead? Some analysts think that GDP growth could accelerate to as high as a 5% annual pace this year. Yet earnings gains are expected to “slow” to a still torrid pace of 19%.

It is hard to tell what changes in trade policy are negotiating ploys, and how much foreshadows lasting damage. But the uncertainty alone unnerves the market. Trade tensions caused a selloff toward the end of the first quarter, and again toward the end of June. The Administration seems to bob and weave, and back away from anything that seems too destabilizing – and the market goes back up. But who knows when this game changes psychology.

We have cut back our exposure to the emerging markets. Neither trade tensions nor higher rates are good for these stocks. The EEM exchange-traded fund was down 9.7% for the quarter. In part, this is because the Chinese stock market has been hit much harder by trade tensions than the US market. These tensions also hurt Taiwan Semiconductor (TSM), which has been a large and profitable position. It fell over 13% for the quarter. It has a compound annual return of over 15% on average over the past ten years and has grown earnings at about the same pace.

Earnings growth and stock price movement do not necessarily go hand in hand. Here is a recent blurb from DC-based Axios on the bank stocks:

“It’s been a strong year for the U.S. economy, but not for Wall Street stocks. The nation’s biggest banks have lost value in 2018, despite generally strong earnings, increased corporate merger activity, rising interest rates and all of them passing their Federal Reserve “stress tests.” There is no firm consensus on why it’s happening.”

In retrospect, the banks have probably lost value because the yield curve has flattened more than anticipated – which means that banks are not getting the net interest margins that had been expected from borrowing at short-term rates and lending at long-term rates.

There is no clear, linear relationship between earnings growth and price appreciation. Here are some of our largest holdings, showing year over year earnings growth as well as total return for the year-to-date.

Company

Ticker

Year Over Year Earnings Growth

Return Year-to-Date

ALPHABET INC

GOOGL

-35.4%

7.0%

AMAZON.COM INC

AMZN

25.5%

45.5%

APPLE INC

AAPL

10.8%

9.6%

APPLIED MATERIALS

AMAT

105.8%

-2.4%

BOEING CO

BA

76.5%

-2.5%

DISNEY

DIS

-0.7%

3.3%

EXXON

XOM

146.3%

-2.6%

GLOBAL PAYMENTS INC

GPN

47.5%

1.5%

HOME DEPOT INC

HD

13.0%

2.7%

INTEL CORP

INTC

-6.1%

-9.4%

JOHNSON & JOHNSON

JNJ

-92.1%

-12.7%

JP MORGAN CHASE & CO

JPM

1.9%

11.1%

KKR

KKR

230.5%

3.0%

LOWE’S

LOW

17.9%

16.1%

MICROSOFT CORP

MSFT

29.0%

15.3%

RAYTHEON CO

RTN

-7.9%

23.7%

SVB FINANCIAL GROUP

SIVB

38.0%

24.8%

TAIWAN SEMICONDUCTOR ADR

TSM

11.0%

-9.4%

TORONTO DOMINION BANK

TD

23.9%

-1.9%

TOYOTA MOTOR CORP ADR

TM

48.1%

13.5%

TRINET GROUP INC

TNET

192.9%

9.7%

UNITEDHEALTH GROUP INC

UNH

47.9%

6.7%

There are more distortions in earnings than in cash flow, but this gives you a sense of the very loose relationship between historical earnings and stock performance.

In our last letter, I wrote that Amazon might be at the top end of its present valuation range based on cash flow at a price of $1600. Since then, the stock has been as high as $1763. But if earnings continue to grow at around 25% per year, then $1600 last January would equate to about $2000 next January. The low end of the range would also move higher.

Advances in health care continue to amaze. Harvard researchers think they may be able to slow or stop the ageing process. A recent headline said the common cold may be a thing of the past within a decade. Enormous advances are being made in the fight against cancer. Health care remains a growth area. One thing that has changed is that major pharmaceutical companies now often buy promising young companies instead of spending huge sums on in-house research. This can make investing in the sector much more speculative. At the same time, the major pharmaceuticals are more boring and growing earnings slowly. J&J, Merck, and Bristol Myers have had negative earnings growth the last three years. Of the three, only Merck is up for the year. Celgene is an even tougher story. It is being drawn into the political rhetoric, and that has put a lid on the stock for the time being. Profitable investing in health care is tilting more toward riskier smaller companies and to health insurers such as United Healthcare. That company has been growing earnings at over 20% a year.

Over dinner with one of the nation’s top investors, he opined that data was the new oil. It makes sense. Information and its storage and sharing are fueling much of the modern economy. Oil stocks did not go straight up in the 1970s, but they were market leaders for a long time. Technology stocks may provide an equally bumpy ride. For instance, Apple has sold off in part because many of its components are made in China, and who knows how trade issues will affect that. And Intel’s stock got hit when its CEO had to resign suddenly. There will be bumps, but technology stocks are likely to continue as the market’s leaders.

Raytheon combines defense and technology with advanced weaponry and surveillance apparatus. Lately the stock has rallied when military tension has been high, and more recently has sold off as immediate threats from the Korean peninsula seem to have subsided. Raytheon’s earnings have grown only modestly in recent years, so this is an interesting case of near-doubling of valuation multiples.

Let’s do a quick review of why rising interest rates tend to be bad for stocks. Many stocks become less attractive from a relative value standpoint because dividend yields compete with fixed income alternatives. Corporate borrowing costs increase. As borrowing costs increase, there will likely be fewer corporate stock buybacks to fuel the market’s rally. At some point, rising interest rates may slow the economy and cause both reduced corporate earnings and a reset of market valuations. Such a prospect seems a long way off, but it is always good to be mindful of risks.

I listened recently to a conversation between Goldman Sachs chairman Lloyd Blankfein and famed trader Paul Tudor Jones, who first became famous by making a lot of money in the 1987 stock crash. Jones expressed strong bullishness in the near term, but voiced concern that the next recession could be brutal because the government has limited monetary policy as an available weapon and has largely rejected countercyclical fiscal policy prescriptions.

But that is not today’s problem. The issue right now is trying to navigate the market’s sector rotations in a prudent fashion, and without incurring too much portfolio turnover. That was not easy in June. Stocks with some of the best earnings growth and valuation metrics did poorly relative to more lackluster companies, which closed a bit of the performance gap. That impacted our relative performance. Meanwhile, supposedly stable stocks such as Procter & Gamble and AT&T were lower for the quarter and year.

Most of the stocks that adversely impacted our performance this quarter still have impressive long-term gains. We can’t dodge every blip. We should have cut back more quickly in certain areas – particularly some housing and airline stocks. It wasn’t so long ago that we were reading that Warren Buffett was finally buying airline stocks as they had figured out how to remain more profitable for longer cycles. Hmmm. As to housing stocks, millennials were supposed to settle down and start buying. But higher interest rates have hurt those stocks. Toll Brothers in particular has been hurt by the SALT provisions in the new tax code, as they build big houses mostly in states with high property taxes. We sold a lot of Toll, but not all of it. Our new positions on balance detracted just slightly but not materially from the quarter’s performance.

As always, we continue to look for promising situations and to monitor risk as carefully as possible, and we appreciate your continued confidence and business as we do so.